I used to work for banks. Now I write about them, and about finance and economics generally. Although I originally trained as a musician and singer, I worked in banking for 17 years and did an MBA at Cass Business School in London, where I specialized in financial risk management. I’m the author of the Coppola Comment finance & economics blog, which is a regular feature on the Financial Times's Alphaville blog and has been quoted in The Economist, the Wall Street Journal, The New York Times and The Guardian. I am also Associate Editor at the online magazine Pieria and a frequent commentator on financial matters for the BBC. And I still sing, and teach. After all, there is more to life than finance.

Banks Are Not Fund Managers

It is widely believed that the job of banks is to “look after our money”. We place funds on deposit in banks, or we buy securities from banks, believing that banks will invest that money on our behalf to generate a return. Most of us expect to be able to retrieve our money whenever we want, and none of us expect to take any losses. Putting money in banks is a safety play.

This post from Deus Ex Macchiato typifies this attitude. Jeremy Stein’s subtle point that for some banks size is determined by funding, not by lending appetite, is taken way too far (my emphasis):

“…banking is a business of (1) attracting deposits and (2) figuring out something to do with them that reliably earns a spread to their cost. Credit extension is a consequence of this activity, not a core part of banks’ business model.”

No, absolutely not. Lending banks DO NOT attract deposits then invest them. They lend, which creates deposits due to double entry accounting. They then seek funding to settle drawdown of those deposits.

Obviously there is a certain amount of circularity here, since a bank that lends excessively faces high and rising funding costs. Markets are perfectly capable of detecting when a bank’s business model is too fragile, as Northern Rock discovered: its funding costs rose progressively for six months before its collapse in September 2007, due to market concerns about the sustainability of its securitization-based funding. Jeremy Stein’s point was that the availability of funds, or rather their cost, is a brake on lending, so it can be said that at the margin a bank’s size is determined by its ability to attract funding at a sufficiently low rate for there to be a profitable spread from lending. Though banks don’t always get this right, as this article in the FT describes for Chinese banks:

“…But in the 1980s and 1990s, the People’s Bank of China was the first port of call for banks whose lending ambitions were larger than their deposit bases could sustain.”

So banks that lend more than they have in deposits are forced to obtain funds from central banks. If they were simply investing deposits, this wouldn’t happen, would it? After all, they would only be lending funds they already have. So how did we have a financial crisis, then? The story of the financial crisis is one of banks relying too much on unstable short-term wholesale funding to close funding gaps arising from exorbitant lending. Please don’t tell me they obtained those unstable short-term funds first then “figured out something to do with them”. No they didn’t. They lent first, then looked for the funds.

Of course, banks do forecast their net funding requirements and expected cost of funds on a daily basis. This is what Libor was: panel banks estimated their expected cost of funds, the British Banking Association (BBA) pooled those estimates, knocked out the outliers and created an average funding cost. As we now know, this way of calculating a benchmark rate was open to abuse. But for a long time it seemed a reasonable way of calculating it: after all, it is in banks’ interests for their expected cost of funding estimate to be realistic, isn’t it? The problem, of course, lies in the use of Libor to price real funding transactions. If banks’ estimates are used to set real prices, banks have a clear incentive to manipulate the estimates in their favor. I am somewhat surprised that the clever people at the BBA didn’t realize how circular the system was and therefore how likely it was that it would be abused. The credibility of the system hung on the honesty of those responsible for creating the daily estimates of funding costs. Sadly that has now been shown to be lacking.

To be sure, there have always been some banks whose purpose is to attract funds and invest them. We had some in the UK until the 1970s: they were called “savings banks” and they were mainly non-profit organizations created to encourage the poor to save. They attracted small deposits which they invested in safe assets (mostly government debt), earning a small spread between the funds placed and the assets purchased. But these days, banks like this are few and far between. They have been largely replaced with fund managers, who do essentially the same job – taking in deposits and investing them to generate a return for themselves and their customers. Fund managers are specialists in portfolio management. But lending banks are not. In fact they are rubbish at it. To them, deposits are funding for lending, not customers’ money to be invested.

Banks like retail deposits because they are more stable than wholesale funds, and for that reason they will usually pay more for them. The idea that retail deposits provide “a cheap form of funding for risky investment banking activities” entirely misconstrues the nature of bank funding. Retail deposits are actually a relatively expensive form of funding. But anyone who thinks that banks “look after their money” or “invest their money” has totally misunderstood the nature of the deal. When you put money in a bank, you have not placed it to the bank for safe keeping, and you haven’t “invested it”: you have lent it to the bank in return for an agreed rate of interest (which for call deposits is probably zero), and the bank can do whatever it likes with that money. If the bank fails, you have no more right of return of your money than any other unsecured creditor. This is why we have governmentinsuranceschemes for deposits.

Of course, banks do sell investments in managed funds to retail customers. And some banks are also fund managers. But that doesn’t mean that banking and fund management are the same thing.

Deposit –taking and investing is NOT the heart of a lending bank’s business. Lending is. And that’s how we like it to be. We expect banks to allocate capital efficiently in the economy. Frankly they are making a complete hash of this at the moment. But they need to get better at their real job of allocating capital, not convert themselves into fund managers. Let fund managers do their job, and banks do theirs. And let’s be completely clear as to which is which.

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